Last week marked a monumental earnings season for big tech. Three of the U.S.'s largest companies: Alphabet (GOOGL) (GOOG -0.17%), Microsoft (MSFT -0.18%), and Facebook (META 1.98%) reported bumper earnings.
Shareholders rejoiced -- but what does it mean for the future? Let's examine these three companies in depth.
Alphabet's second quarter 2021 results were incredible. Total revenue grew 62% (or 57% constant currency). Yes, a good portion of this growth is the result of an easy year-over-year comp because Alphabet was lapping its first ever revenue decline in its core advertising business last year due to COVID. Nevertheless, the growth is impressive on a two-year stack basis and a testament that Alphabet is perfectly positioned to benefit from the digital revolution in all facets.
The impressive topline growth was driven by 68% growth in search, 84% growth at YouTube, and 54% growth in Google Cloud. I continue to believe that YouTube is one of the most valuable media assets in the world (with 2 billion MAUs and 1 billion hours of video watched every day), and that Google Cloud is gaining relevance among enterprise clients and taking market share under the leadership of Thomas Kurian. Alphabet CEO Sundar Pichai believes that Google Cloud has leading software tools for AI, data analytics, and cyber security based on its pioneering work in zero-trust architecture. Additionally, there's no doubt in my mind that Waymo is a leader in autonomous vehicle technology that is already commercialized on a small scale in Phoenix. I think YouTube and Google Cloud are probably underearning and that Waymo presents Alphabet with incredible optionality.
The two highlights of the call for me were that (1.) Alphabet CFO Ruth Porat emphasized multiple times that the company is still in aggressive investment mode given the "long-term quality growth" opportunities that it sees and (2.) Pichai emphasized that the company will continue to invest heavily in artificial intelligence (AI) because it is a "fundamental technology" that "underpins and dramatically improves" all Google products. I've said it many, many times before and I'll say it again: Alphabet is the surest ways I know of to invest in AI and machine learning (ML) because it's an AI-first company, meaning that the technology cuts across everything the company does. Alphabet uses AI to decipher images in Google Photos, for its self-driving cars, to understand speech for Google Home, to translate languages, to produce caption videos in YouTube, to detect toxic , violent, or extremist content that violates their policies on YouTube, to find the lowest carbon -intensive driving route in Google Maps, to improve the efficiency of its data centers, to help diagnose disease, and much more.
Despite underearning (at some point its net operating profit after tax [NOPAT] margins should explode higher), Alphabet generated a TTM ROIC of 38% (according to New Constructs), which is above its 5-year average ROIC of 32%. The increase in return on invested capital (ROIC) has been driven by a consistent increase in invested capital turns, which means that Ruth Porat wins huge points for managing the balance sheet more efficiently. It also means that ROIC has more room to move higher over time as it improves profitability at YouTube, Google Cloud, and some of the other bets.
It generated a 26% free cash flow (FCF) margin, and its balance sheet has a whopping $109 billion in net cash. The fact that Alphabet can invest somewhere in the neighborhood of $50 billion per year into long-term growth (through R&D + Capex + Acquisitions) and still generate so much excess free cash flow that it doesn't' know what to do with means that it has one of the strongest balance sheets in the world, which provides it with unbelievable amounts of optionality and the ability to grow per-share value with massive buybacks down the road as it will now use some of its FCF to repurchase both Class A and Class C stock.
Microsoft's fiscal year 2021 revenue increased 18% to $168 billion. Its operating income increased 32%, net income increased 37% to over $60 billion, and its diluted non-GAAP EPS grew 38%. Its full-year operating cash flow increased 26% to $76.7 billion, but capex grew nearly 34% to support the buildout of its global cloud, so free cash flow (FCF) increased 24% to $56 billion (which results in a F2021 FCF margin of 33%). Microsoft generated a trailing twelve month (TTM) ROIC of 44%, which is up from 29% in 2016 and above its five-year average ROIC of 32%. Its consistent increase in ROIC is driven by a consistent increase in NOPAT margins in each of the past five years as well as an increase in invested capital turnover (balance sheet efficiency) in the last couple years. The combination of mid-teens revenue growth the last several years plus rising returns on invested capital has powered Microsoft's intrinsic value much higher, and this is reflected in a market valuation that has soured above $2 trillion. Microsoft has $49 billion in net cash, which combined with its enormous FCF generation, creates enormous optionality.
The most important takeaway from the call is that Microsoft is seeing an "increase in the number of larger long-term Azure contracts." This is important because it shows that Microsoft's strategy of having the widest, most comprehensive suite of software solutions is paying off in spades. A client may sign up for core Azure (Infrastructure as a Service), but then Microsoft can sell those clients an almost unlimited menu of additional software applications across the full software stack. This ability to sell additional products/services to an existing customer base is a form of pricing power. This also improves customer service and leads to larger long-term cloud contracts, higher customer retention (increasing switching costs), and faster growth and higher margins for Microsoft. And this can clearly be seen in Microsoft's numbers. Since 2016 Microsoft's gross margins have increased from around 64% to over 68% and its EBIT margins have increased from around 30% to around 40%. This margin expansion is a key driver of the consistent increase in ROIC described above. And on the call, CFO Amy Hood said that she's proud of the work the company has done on "margins and returns" and she suggested that there is room for further margin improvement.
Microsoft's suite of cloud-based software solutions include everything from Azure (second largest hyperscale IaaS cloud) to Office 365, to remote/hybrid work, collaboration and productivity with Microsoft teams to cybersecurity with Microsoft Defender, Microsoft Sentinel, Microsoft Endpoint and Azure AD, to developer tools in Github, to low -code/no-code software tools in Power Platform to CRM and ERP with Dynamics 365, to database and data warehousing with Cosmos and Azure Synapse , to AI with Azure Applied AI, to gaming with Xbox, Minecraft, and flight simulator to talent solutions and online learning with LinkedIn to human capital management software with Microsoft Viva. And, most importantly, it is gaining share in key areas including Infrastructure as a Service (core Azure), customer relationship management (Dynamics), cybersecurity, and collaboration and hybrid work (Teams). In this way, it is perfectly positioned to facilitate a transition to a digital-first, cloud-first, AI-first world.
Facebook's second quarter 2021 results were very strong. Revenue increased 56% (or 50% constant currency) but expenses only increased 31% so its operating margin expanded 1,100 basis points to 43%. The massive topline growth combined with operating leverage resulted in net income and EPS growth of 101%. Facebook generated a TTM ROIC of 45% (according to New Constructs), which is above its 2017-2020 average ROIC of 41%. Facebook's ROICs have been driven by five consecutive years of increased invested capital turnover (increased balance sheet efficiency) and an increase in NOPAT margins over the trailing twelve months. Facebook generated $8.5 billion in free cash flow (FCF) for the quarter, which is defined here as operating cash flow less capex less principal payment on leases. This equates to a 29% FCF margin. Facebook has net cash (cash less capitalized leases) of nearly $52 billion, which combined with its large FCF generation and Mark Zuckerberg's vision to become a metaverse company (more on that below) creates enormous optionality.
Facebook's top line growth was driven by 6% growth in the number of ads (impressions) and a 47% increase in the price per ad (i.e. pricing power). Impression growth appears muted, but remember that Facebook was lapping an extremely strong quarter when impressions were extremely strong due to the global lockdown and shelter-in-place orders. But going forward, CFO Dave Wehner says "we've got a number of impression growth opportunities" and he emphasized that "I think Reels is a really significant future opportunity. We've only just really begun to make ads available globally on Reels."
The results also show that businesses of all sizes are wiling to pay Facebook more for better ad placement, better return on ad spend, and better measurement of ad effectiveness. Facebook's results (as well as those of digital advertising leader Alphabet) also show that the digital advertising market is very large and growing, and that the shift to digital advertising was likely accelerated by the pandemic. Also, if you're looking for an inflation hedge, I don't think you can do much better than a company like Facebook with massive returns on invested capital and pricing power.
Monthly active people (MAPs) on at least one of Facebook's properties grew 12% to 3.51 billion and daily active people (DAPs) on at least one of Facebook properties also grew 12% to 2.76 billion. The engagement ratio at core Facebook remained strong and steady at 66% and the engagement ratio across its family of products also remained strong and steady at 79%.
There are roughly 7.9 billion people on the planet, so this means that roughly 35% of the global population uses at least one Facebook app every single day. This is especially impressive considering that only about 60% of the world is considered an active Internet user according to Statista. In other words, Facebook has an absolutely massive network of global users that it can slowly transition over into its future metaverse. OK, so what is this metaverse?
Zuckerberg defines the metaverse as a virtual world that you are "present" in. He says it is an "internet that you're inside of rather than just looking at." In other words, the metaverse is a series of virtual worlds where people (through avatars) will go to spend their time and their money (a virtual economy is another defining characteristic of the metaverse). He says that the metaverse will be the "successor to the mobile Internet" and that Facebook will transition from being primarily a social media company to a metaverse company. Zuckerberg thinks that this fits with the company's mission of bringing people closer together because these virtual worlds are where we will go to spend our time and money (something that I've been saying publicly on Motley Fool Live and in our team Slack channel for over a year now). At this early stage, Zuckerberg says that the Facebook business model for the metaverse will still be based around advertising and commerce (virtual purchases within these virtual worlds). As far as earnings calls go, this was a really important one because Facebook is one of the largest (and sometimes controversial) companies and tech platforms in the world and Mark Zuckerberg laid out his long-term vision for the future of the company!
But this will be a multi-year transition. In the meantime, Facebook continues to invest in tools for content creators including video (such as Reels and Facebook Watch), publishing (Bulletin), Live audio rooms (think Clubhouse), and podcasts. It also working to incorporate and embed e-commerce (Facebook Shops) and digital payments solutions across its platform to make it easier for users to shop and easier for businesses to make money and grow. Facebook is also investing heavily into AR/VR with Oculus and its upcoming smart glasses, developed in partnership with Ray-Ban parent EssilorLuxottica. Clearly AR/VR will be one of the defining technologies of a next-generation computing platform shift over into the metaverse.
The three key takeaways on the call were: (1.) Mark's vision for the future of the Internet and the future of Facebook becoming a metaverse company, (2.) Dave Wehner's comments that Facebook is still in heavy investment mode to the tune of over $70 billion in total expense for 2021, and (3.) Mark Zuckerberg's thoughts on the progress Facebook has achieved in building an AI platform that permeates the whole company and improves the performance of tech products and systems across the whole company. I continue to believe that the leaders in AI and ML are going to be the mega-cap tech companies. If you want to know what optionality (unquantifiable future value creation) looks like, look no further than Facebook.